In an amended filing of the proxy for Berkshire Hathaway’s proposed acquisition of Burlington Northern Santa Fe, new details have been provided regarding Burlington Northern’s management forecasts of future results based on a number of different macroeconomic assumptions. The restrained nature of the forecasts and the fact that management projections for 2010 net income is lower than Wall Street consensus forecasts even under the most optimistic scenario was the subject of an article in Barron’s over the weekend.

In addition, Warren Buffett’s comment during negotiations that Burlington Northern is worth approximately mid-$90s per share has attracted attention particularly given Berkshire’s use of stock to fund part of the transaction. Let’s take a brief look at some of the more interesting information in the latest proxy filing.

Excess Conservatism or Better Insights?

As the Barron’s article points out, Burlington Northern forecasts earnings per share of $5.04 in 2010 under its most optimistic scenario. This falls short of the Wall Street consensus of $5.50 for 2010 earnings per share. Furthermore, since Burlington Northern management indicates that they believe a 2011 recovery is more likely, earnings per share might be even lower. For full details regarding the four scenarios presented by Burlington Northern, please refer to pages 42 to 44 of the proxy document.

The Barron’s article implies that Burlington Northern’s management prepared the scenarios and estimates after the merger was proposed in November. However, the proxy statement indicates that the management cases were prepared in September prior to an annual board meeting devoted to a discussion of long term plans. These management cases were provided to Goldman Sachs and Evercore Group in late October as inputs into the independent valuation analysis these firms performed for Burlington Northern during the board’s deliberations on Berkshire’s proposed acquisition.

Management came up with four scenarios: 2010 Recovery, 2011 Recovery, No Recovery, and Deeper Recession. The Board instructed Goldman Sachs and Evercore to regard the 2011 Recovery case as the most probable. This scenario calls for earnings per share to increase from $4.41 in 2010 to $9.35 in 2014. The more optimistic 2010 Recovery case projects earnings per share to increase from $5.04 in 2010 to $10.96 in 2014. The No Recovery case calls for essentially flat earnings on average over the five year period while the Deeper Recession case obviously projects even worse results.

Does this imply that Burlington Northern’s management is being much more conservative than Wall Street analysts? It seems that the answer is yes given that the “most likely” scenario is the 2011 Recovery case rather than the 2010 Recovery case. As we have discussed in the past, railroads are a “derived demand” industry meaning that business trends can provide great insight into overall economic conditions. Since rail indicators continue to show relatively weak results, it seems prudent for management to exercise caution when making long term plans.

“Fair Value” for Burlington Northern: Mid-$90s Per Share?

On pages 36 to 39 of the proxy, a detailed account of the merger discussions is provided. One portion of the discussion is particularly interesting for Berkshire Hathaway shareholders:

[b]Mr. Buffett expressed his belief that fair value for BNSF’s common stock was in the mid−$90s per share, and that therefore the $100 per share price he was contemplating was, in Mr. Buffett’s view, as high as Berkshire could pay.[/quote]If fair value for Burlington Northern was in the mid 90s per share, then why did Mr. Buffett agree to offer $100 per share? As he stated at the time, the transaction is obviously a major bet on the United States economy. This does not mean that a recovery is imminent in 2010 or even in 2011, but obviously Mr. Buffett believes that rail traffic will be substantially higher five to ten years from now.

One aspect of the transaction that troubles many Berkshire shareholders is the fact that stock is being used to fund 40% of the purchase price. As we discussed in coverage of the transaction at the time of the announcement, Mr. Buffett does not believe in issuing Berkshire stock unless Berkshire is receiving as much or more intrinsic value in return. If Burlington Northern shares are “fully valued” in the mid-$90s per share range and Berkshire is using stock to fund part of the $100 per share acquisition, then are Berkshire shares fairly valued or overvalued?

While it is certainly possible that Mr. Buffett regards Berkshire shares as fairly valued, two points must be made that could lead to a different conclusion: First, in any merger transaction, the acquirer is obviously not going to brag about obtaining terms that undervalue the acquisition target. While Mr. Buffett may regard Burlington Northern as worth no more than $100 share today as a stand alone publicly traded company, he apparently has a positive view of the United States economy that can support a much higher valuation for Burlington Northern five to ten years from now. Second, it is possible that Mr. Buffett believes that Burlington Northern is worth more as a Berkshire subsidiary than as a stand alone public company. The fact that Berkshire has significant cash flow from operations to invest each year along with the ability to borrow at very low cost is a great match for a business that requires steady capital investment.

The definitive answer to the question of whether Berkshire is overpaying for Burlington Northern will not be known for several years. However, use of Berkshire Hathaway stock as a funding source at a time when Berkshire’s share price is clearly “on sale” based on a number of measures we have discussed in the past is cause for legitimate concern. The stakes are high and macroeconomic factors rather than the execution of Burlington Northern’s management will play the predominant role in determining the outcome.

Here is development of S & P railroad average prices and P/E ratios, from “Intelligent investor”.

Year Price P/E

1948 15.27 4.55

1953 22.60 5.42

1958 34.23 12.45

1963 40.65 12.78

1968 54.15 14.21

1970 34.40 12.83

Of course, Burlington Northern is not average railroad and entire industry is quite different after huge consolidation, All What i can say, you have to pay hefty prices for forefront railroad these days.

Ranni also tells the truth. First, shedding a dim light on BNI's future earnings forecasts per analysts. Then, Ranni, reliving the abysmal 1948-1970 era (while citing "Intelligent Investor" as the source) for more drowning sorrow. I will say, the irony Ranni's message also reverberates (defined as, rebounds) with the first page of another one of Ben Graham's classic's "Security Analysis", where the first page references Horace's Ars Poetica. That page, goes like this, "Many shall be restored that now are fallen and many shall fall that now are in honor."), and I'm sure there was more underperformance wrapped around the boundaries of those years.

In any event, Ranni ends with another truism, being that the railroad industry has a far different business model than 1948-1970 (and even far beyond just those dismal years), and how premiums are now paid for "locked-lands".

Again, ironically, the only mistruth (in my opinion) comes from the aforementioned phrase, "Mr. Buffett expressed his belief that fair value for BNSF’s common stock was in the mid−$90s per share, and that therefore the $100 per share price he was contemplating was, in Mr. Buffett’s view, as high as Berkshire could pay."

As anyone can plainly tell, Mr. Buffett isn't telling a lie. Afterall, he "expressed" (ie. must have told someone) , BNI is worth, "in the mid-$90s per share, and that... $100 per share price (which was the offered price, was) as high as Berkshire could pay."

The wording almost sounds like Buffett and Berkshire is going broke in order to make this deal.

Folks, this is Classic Buffett!

BNI is worth over $200/share, imo, but it won't get realized anytime soon - most likely, it'll get noticed sometime after Buffett retires five years after his death.

A company is worth the present value of its future cash flow, correct? Then WEB is totally wrong about the present value of BNI's future cash flow? It not worth in the mid 90's, but rather $200 a share! I am surprised every investment manager in the country didn't "back up the truck" if that's the case. Mid 90's seems more plausible to me.

BNI is worth over $200/share, imo, but it won't get realized anytime soon - most likely, it'll get noticed sometime after Buffett retires five years after his death.

I agree with Vooch, This is classic, we cannot think that Oracle of Omaha would make this size of merger, without having the last laugh. This is same kind of situation what we have seen with Coca Cola or other purchases, where guys thinks he is nuts by using some fancy DFC models or other NPV valuation methods. They were not able to see with these models those hidden values like untapped pricing power and strength of brand.

It seems same kind of thing; Brk owners are able to collect these fruits over longer period of time.

Of course Buffet is not going to show all he’s cards at this point, when we are talking about prices, but I would bet there is still an ace up one's sleeve.

Even i said all this, I still think takeover was overpriced, and there would be lot of better opportunities to make money for owners short – mid term, than with this.

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